A Cash Flow Statement is the last of the three financial statements that records all the incoming and outgoing cash of the business. It connects the income statement and the balance sheet by showing how cash has flowed throughout the business. The Cash Flow Statement unlike the other statements is a record of the actual real cash that has changed hands and is not based on non-cash transactions.

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What is the Cash Flow Statement?

The Cash Flow Statement is the most important of the three financial statements. It is often overlooked by investors, but it provides crucial information. Unlike the Income Statement and balance sheet, which are based on accrual accounting, the Statement of Cash Flow shows the actual cash exchanged in business operations.

Cash is essential for a business’s operations, investments, and growth. The Cash Flow Statement, based on the principle that “Cash is King,” clearly demonstrates the inflow and outflow of money over a specific period.

The fact is that one of the earliest lessons I learned in business was that balance sheets and income statements are fiction, cash flow is reality.

Chris Chocola

For a business, cash is crucial. While profits are important, a company needs cash to function effectively. The Cash Flow Statement provides insights into a business’s cash position and its ability to meet operational expenses and invest for expansion.

Understanding the sources and uses of cash is vital for investors to comprehend a company’s business model, management practices, and operational performance. The interpretation of the statement will provide details about the company’s spending, and the critical payments the company makes. Investors will also know the optimal amount of cash the company needs to have on hand by being aware of the working capital needed.   

Why is the Cash Flow Statement important?

Both investors and management need to understand how well the business is generating cold hard cash and how much it has at any given point in time. To effectively plan and execute on the business strategy, management needs cash to be able to do this. The Income Statement and Balance Sheet don’t represent what actually happens to the cash that settles from customers and what goes out to keep the business moving forward.

Investors need to understand where the cash comes from, how the business got the cash, and where this cash ends up going. The cash flow statement is the bridge between these statements. By comparing cash flow against the company earnings we can see how the management is performing and how effective they are at running the business.

The statement of cash flow is important as it puts the business model into context and shines a light on how the business converts its revenue and net income into value for shareholders.

If we compare the statements to our personal circumstances, the Income Statement is the representation of your income and your personal expenditure to live. The Balance Sheet represents your “Net-Worth,” what you own and what you owe. The Cash Flow Statement represents your bank account or checking account. It captures exactly what money has come in and what has gone out.

This is why it is an important statement because it is based on reality of what the company actually received from operating and what it spent to achieve its revenue. Investors must understand all the transactions that go into a business and determine which ones are necessary for the business to thrive and succeed.

Direct Method & Indirect Method.

There are two methods used when the CFO decides to summarize the cash flow statement: the indirect and direct methods. Both methods result in net cash flows from operating activities.

Direct Method: This method begins with all the cash received from sales or revenue that settled into the company’s bank account. It then deducts all the cash outflows for operational expenses. The direct method is a simple approach based on transactional information and is the preferred way to build the cash flow statement according to accounting practice.

Indirect Method: This method is more commonly adopted by companies and is based on a “reconciliation of cash” approach. It starts with the net income from the income statement, which is then adjusted for depreciation, amortisation, and other non-cash items like gains and losses.

We have to account for some non-cash items and make certain adjustments to earnings because items like depreciation do not involve any cash changing hands, i.e. no transactions take place. Therefore, we need to reconcile the net profit to account for these items.

How to read a Cash Flow Statement?

Reading the Cash Flow Statement can be tricky for newcomers, but once you understand the flow and how each line item is broken down, it becomes quite easy to scan. The simple equation to remember is this: Beginning Cash Balance + Cash In – Cash Out = Ending Cash Balance.

💰 Beginning Cash Balance

The cash balance from the previous reporting period whether quarterly or annually.

➕ Cash In

All the cash flow coming in during the new reporting period. Cash from either receipts, sale of stock, net borrowings and all incoming cash into a bank.

➖ Cash Out

All the cash flowing out during the new reporting period. Cash outflows from operating expenses, investment activity, taxes and other fixed asset purchases.

🟰 Ending Cash Balance

All the cash that came in minus the cash that went out plus the Starting Cash Balance will equal the new ending cash balance. It can be negative or positive.

In this next section, we will break down the three areas of cash flow. However, this is how the cash flow statement flows and should be read.

The Key areas of the Cash Flow Statement.

The Cash Flow Statement is divided into three sections: Operating activities, investing activities, and financing activities. These sections provide insights into where the cash came from and where it was spent.

To calculate the company’s net cash flow, we add up the cash flows from operating activities, investing activities, and financing activities.

Net Cash Flow = Operating Activities + Investing Activities + Financing Activities

A positive net cash flow indicates that the business has more cash at the end of the period than it started with. A negative net cash flow means the business has less cash than it started with and is spending more cash than it is bringing in.

Operating Cash Flow

Operational activities encompass the transactions directly associated with the primary business operations. This includes all the cash inflows and outflows from the core revenue-generating and operational expense activities. It’s crucial as it allows us to track how much revenue is being converted to cash. This section pertains to the top line items of the Income Statement and provides a breakdown of all the cash flow from the products and services sold, as well as the cost to deliver the revenue.

Cash Inflows: All the cash that the company has collected, i.e., the top-line revenue that has been paid already. Cash receipts are not profits. The cash receipts are the money that hits the bank account and is then reported on the balance sheet as cash on hand.

Cash Outflows: This includes all the cash that has been paid out (disbursements) to keep the operations running, such as rent, salaries, wages, cash payments to suppliers and vendors, taxes paid, stock repurchases, and all costs to operate the company. This encompasses inventory transactions, cost of goods sold, and interest payments on debt.

Operating ACtivity will include all the changes in current assets and current liabilities (all the costs that are due within a year).

Cash From Operations = Cash Inflow (Receipts) – Cash Outflows (Disbursements)

The best outcome for most companies is to have more cash from operating income exceeding net income. This results in positive cash flow or Free Cash Flow, which is the true measure of a company’s worth. If a company can generate sufficient positive cash, it has more money to expand, reinvest in growth, or reward shareholders directly.

Investing Cash Flow

Investing Activity reflects the transactions and changes to cash related to investing activities such as acquisitions or the sale of long-term assets or other investments. The investment activities include the purchase of fixed assets. This is where you will see PP&E on the balance sheet (Property, Plant, and Equipment). Making purchases to expand operations is considered an investment activity because it should increase overall revenue.

The investing activities will often have the depreciation and amortisation schedule associated with them from the Income Statement. D&A is used to write off the initial cost of the investment over a certain time frame to reflect the loss of value from the initial purchase. This then becomes a non-cash line item as it impacts cash flow but is not transactional-based (no one gives you physical cash to write your assets off).

Capital Expenditures (CapEx) is a critical item in the cash flow from investing section. Increases in CapEx show that the company is investing for the future, and positive free cash flow generated from operating activities means there will be more cash flow to reinvest in the business.

The investment activity will reflect a gain or a loss. This gain or loss impacts the cash position of a company. Negative cash flow is not necessarily bad; a company may be investing significantly in growth, which decreases the cash flow. Usually, a highly profitable growth business will have negative free cash flow until it scales to a size where it can reduce investment costs, which then generates a lot of free cash flow.

There can be cash inflows from investing activity, which occurs when the business sells property, plant, and equipment, and investments in bonds or other companies. Generating cash flow from this section is not ideal, as it is not operational based.

Financing Cash Flow

Financing activities pertain to the cash transactions involving the shareholders and creditors of the business. This section encompasses anything related to debt and equity activities. It includes the issuance of dividends, repayment of loans, raising capital by issuing more shares, and any debt the company takes on.

Cash inflows occur from borrowing money, as a loan brings in cash, and from raising capital by issuing more shares. When a company issues shares, shareholders exchange cash for stocks, bringing cash flow into the business. All these activities increase the cash on hand as the company brings in more cash.

Cash outflows relate to the business buying back shares, using cash flow to repurchase shares on the open market, paying back debt, or rewarding shareholders with a dividend. These activities decrease the cash on hand as the money flows out of the business.

Anything related to debt and equity will be found in this section, providing a great way to understand the company’s capital structure and the costs of capital. If the number is positive, it indicates that more cash is coming into the business, and if it is negative, it means more cash is going out of the business.

Using the Direct Method and Indirect Method.

Below is a table on each of the methods to show how you can determine the net cash flows on each section and then work out the closing end balance.

Cash Flow Statement – Direct Method Example

Line Item	Amount
Beginning Cash Balance	$0 – Starting Balance
Operating Activity Cash Flow
A) Cash Receipts on Revenue – Only what cash has changed hands.	+ $ What cash has come in.
B) Operational Expenses (Wages, Taxes, Rent, Suppliers)	– $ What cash has gone out.
C) Net Cash From Operating Activity	C = A – B
Investing Activity Cash Flow
D) Sales of PP&E or Fixed Assets	+ $ Cash Proceeds
E) Purchase of PP&E or Fixed Assets	– $ What cash has gone out from the investment.
F) CapEx (Capital Expenditures)	– $ The cash gone out from investments.
G) Net Cash From Investing Activity	G = D – E – F (Usually a negative)
Financing Activity Cash Flow
H) Cash from issuing shares or borrowing money.	+ $ What cash come in from financing.
I) Debt repayment	– $ What cash has gone out to repay debt.
J) Dividends paid out.	– $ The Cash paid out as dividends.
K) Net Cash from Financing Activity	K = H – I – J
ADD NET CASH FLOWS FROM ALL 3 ACTIVITIES	C + G + K
NET CASH + BEGINNING CASH =	$ ENDING CASH BALANCE

You can see how the direct method flows and is simple to understand. Now let’s work through an example of the Indirect method to understand the key differences.

Cash Flow Statement – Indirect Method Example

Line Item	Amount
Operating Activity Cash Flow
A) Net Income	$ The starting net income from the Income Statement.
B) ADD: Non-operating expenses (Depreciation, Accounts payable, any accrued expenses).	+ $ Add these line items to the Net Income
C) LESS: Non-operating Income (Accounts receivables, prepaid costs, revenue not earned)	– $ Minus all non-operating costs.
D) Operating profits before changes to working capital	D = A + B – C
E) ADD: Decrease in current assets and increase in current liability	+ $ The changes in current assets and current liabilities.
F) LESS: Decrease in current liability and increase in current assets	+ $ The changes in current liabilities and current assets.
G) Net Cash From Operating Activity	G = D + E – F
Investing Activity Cash Flow
H) Sales of PP&E or Fixed Assets	+ $ What cash has come in from the sale.
I) Purchase of PP&E or Fixed Assets	– $ What cash has gone out from the investment.
J) Net Cash From Investing Activity	J = H – I
Financing Activity Cash Flow
K) Cash from issuing shares or borrowing money.	+ $ What cash brought in from financing.
L) Debt repayment	– $ What cash has gone out to repay debt.
M) Dividends paid out.	– $ What Cash has been paid out as dividends.
N) Net Cash from Financing Activity	N = K – L – M
ADD NET CASH FLOWS FROM ALL 3 ACTIVITIES	G + J + N
NET CASH + BEGINNING CASH =	$ ENDING CASH BALANCE

This table reflects the way the indirect method works and the impact of the operational activity based on reconciling net income. Both methods work, however the indirect can be more useful especially considering the impact of non-cash items.

What do I look for on the Statement?

The cash flow statement is where I spend a lot of time analysing. Cash flow does not lie and is a very good indicator of what is going on within a business. The best way to reflect how well a company is doing is by analysing the three activities of cash flow to see whether the company will continue to generate a lot of free cash flow in the future.

I always read the reconciliation report which connects the income statement to the statement of cash flows. In some countries, the statements are not connected and the details are buried within the notes to the financial statements. It is best to read these to understand the numbers. For example, working capital is often broken down in the reconciliation component.

The core focus is primarily on three areas. Is there healthy cash receipts? I want to see net cash from operating activity closely mirror net income. Customers and revenue need to convert to actual cash. The cash receipts are a great indicator to see if this is happening. If it isn’t, Why?

Cash conversion is important, I look at net cash from operations and measure against revenue or net profit to give me a look at the margins. Sometimes it is because of an accrual accounting method and other times it’s because something is wrong.

Then, secondly, I look at the free cash flow by taking net cash from operating activity and deducting capital expenditure. I am always looking for a positive but am not turned off by a negative FCF if the company is scaling.

Lastly, I spend time studying the changes to working capital. Areas such as inventory or accounts turnover can give me insights into the operational performance of the business.

Investment Ratios to use.

These are the most common ratios related to the Cash Flow Statement. These are the ratios I use the most. Especially free cash flow. This is the “Owners Earnings” and a great indicator of the overall health of the business.

• Free Cash Flow: Net Cash Flow from operating activity minus Investing Activity (CapEx).
• Price-to-Cash Flow: Looks at how much cash flow per share investors are getting.
• Operating Cash Flow Margin: Measures how much cash flow is converted from revenue.
• Cash Flow Coverage Ratio: Measures how much cash is generated to cover paying off debt.
• Cash Flow to Earnings: Measures the efficiency to convert net income from operating activity.

➡️ Learn more about Investment Ratios.

An example of a Cash Flow Statement?

Extending from the Income Statement and the Balance Sheet examples, we will use the Cash Flow Statement of the same small-cap company in our example. Once again, the owner-operated company presents the statement clearly and precisely, aligning with the other two statements.

Breaking down this statement, we can analyse the three sections quite simply. First, I would look at the Free Cash Flow by taking Net Cash from Operations, which is $7.7 million, and deducting CapEx costs labelled under Plant and Equipment, which amount to $1.3 million. Deducting this from our Operational Cash Flow gives us a “back of the envelope” estimate of FCF, which is $6.4 million. This is a very healthy amount.

If we divide operational net cash flow over revenue, we have a healthy cash conversion margin of approximately 20%.

Then, I would look at the Cash Receipts, which are very healthy. The company has long-standing customers and strong contracts, so it converts a lot of cash from reported revenue. We can also see that financing costs have changed compared to last year and are negative. The previous year had a positive amount as the company raised money via a share issuance. This current year is negative as the company paid a small dividend and paid off some long-term debt, hired equipment, and fulfilled contractual leases. This resulted in a cash outflow.

Finally, we can see that the cash we started with on the balance sheet last year, plus the positive increase in cash flow, results in an $8.9 million Cash Ending Balance. This will be the beginning cash amount for the next reporting period.

While this is a simple example of a real cash flow statement, the basis of interpretation will be similar once you grasp the basics.

🚩 Red Flags to keep an eye on?

There are a few red flags to look for when observing the cash flow statement. Here is a list of the areas I frown at when I notice them. Some are of more concern than others, all should be investigated thoroughly to understand why it is occurring.

Cash Receipts does not mirror Net-Income

As we’ve touched on this is crucial. Cash Receipts in the cash flow statement should be close to earnings. This indicates that customers are paying their bills and revenue is not just vanity. Profit is important, rising revenue is important but these are nothing to a business if they don’t convert to cash. Cash is what the company needs to pay bills, reinvest and reward shareholders. Small companies and growth businesses can get away with not converting cash for a short period of time but all companies need to have healthy cash receipts eventually.

Operating Cash flow lower than Net Income

Here operating cash flow should be higher than net income. The net cash flow from operating after all the deductions should be positive and higher than earnings. If the number is lower then there is an issue with converting profits to cold hard cash. There could be an issue with inventory piling up which would be reflected in the changes in working capital. Always look for a higher number.

Capital Expenditure is a high portion of earnings

Companies need to reinvest to continue to grow. However, spending far too much free cash flow in proportion to net income can indicate the company is not being prudent. If the opportunities merit the spending and increase in investing activity great. As a business gets bigger, stabilises in does not need to spend as much on reinvestment opportunities and so may be wasting this free cash flow. To check this, look at the proportion of CapEx activity against net income and also the returns on capital to see if the company is being efficient.

Increases in Debt or Equity

Over time we want companies to generate free cash flow to pay down debt, reward shareholders by either buybacks, dividend payments or reinvesting cash at higher returns than we can get. When financing activities on the cash flow statement start to increase and be positive it means the company is either borrowing money or diluting shareholders. If the money is positive it means cash has come IN from financing activities. Over time we want it negative meaning debt repayments, buybacks or the issuance of dividends have paid out cash.

Negative Cash Balance

Over time we want a positive and increasing cash balance. Some companies in growth mode with clear futures worth investing in can have a negative cash balance for a period of time. However, over the long term, we want a positive cash balance. All quality long-term compounders generate positive free cash flow. If the company is negative but boasting profit we want to ensure the returns on capital are high, and the company has a clear path to generating positive free cash flow.

Operating Cash flow less than Capital Expenditures

If the company has more CapEx demands than operational cash flow it will need to raise capital by taking on debt or via an equity raise. A company needs to earn more net cash from its operational activities to help fuel growth by spending on capital needs. It becomes a vicious cycle having more capital needs than cash flow which usually relates to the company having to raise funds at the worst of times. Raising capital by debt and equity is not bad, but over time a company should move towards self-sufficiency by covering CapEx from cash flow.

In Summary…

This is my summary of the cash flow statement and how to interpret it. For smaller growth companies, I focus on operational activities, while for more established companies, I pay attention to investing activities. Operational cash flow is crucial for smaller companies as it helps them scale their business, even if the overall cash flow balance is negative. A company can be profitable but reinvest all the cash into growth mode, potentially creating significant wealth for shareholders if done correctly.

As a company matures and generates positive free cash flow, I expect the investing activities to provide a higher return than if the company were to give me the cash back as a dividend. If a company cannot earn high returns on its investment activities, it should return that cash to shareholders.

The cash flow statement is essential in my analysis of companies as it provides insights into various areas simultaneously. It shows the operational efficiency of the business, the reality behind the “opportunity” on the income statement (i.e. revenue), and provides insights into the effective management of risk on the balance sheet. Most importantly, it demonstrates how effective the company is at converting sales to cash and reinvesting it to earn and grow more.

One of the essential areas to understand is the working capital cycle of the business. Understanding the timings between getting paid, when the company owes suppliers, and how the company pays and handles inventory are all key indicators to understanding the operations of the business model.  

The cash flow statement sheds light on all these activities and helps connect all the financial statements together. It’s worth spending time understanding each of the primary activities – operational, investing, and financing – as it provides valuable insights to guide investment decisions.